Chapter 2 :Applying Time Value Concepts

Transcription

1 Chapter 2 :Applying Time Value Concepts 2.1 True/False 1) Time value of money is based on the belief that a dollar that will be received at some future date is worth more than a dollar today. Diff: 1 Type: TF 2) Future value depends on the interest rate and number of years invested but is independent of the number of compounding periods. Diff: 1 Type: TF 3) The present value of an annuity can be obtained by discounting the individual cash flows of an annuity and totalling them. Diff: 1 Type: TF Categories: Present Value of an Annuity 4) To convert the table from ordinary annuity to annuity due is to multiple the annuity payment by (1+ i). Diff: 2 Type: TF Categories: Present Value of an Annuity 5) Ten percent compounded quarterly with 10 years' investment means 40 compounding periods. Diff: 1 Type: TF 1

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3 6) The shorter the time period, the lower the future value interest factor, other things being equal. Diff: 2 Type: TF 7) The longer the time period, the higher the present value interest factor, other things being equal. Diff: 2 Type: TF 8) The higher the interest rate, the higher the future value interest factor, other things being equal. Diff: 2 Type: TF 9) The higher the interest rate, the lower the present value interest factor, other things being equal. Diff: 2 Type: TF 10) If you invested $ when you turned 20 years of age and received a return of 11 percent annually, you would have over two million dollars when you turned 70. Diff: 3 Type: TF 11) Dividend is the rent charged for the use of money. Diff: 1 Type: TF 2

4 12) Compound interest means earning interest on interest. Diff: 1 Type: TF 13) The concept of time value of money only applies to rare financial planning problems. Diff: 1 Type: TF 14) The process of obtaining a present value is called discounting. Diff: 1 Type: TF 15) Present value of the first year is determined by the future value divided by (1 + i). Diff: 2 Type: TF 16) The nominal interest rate is also called an annual percentage rate (APR). Diff: 1 Type: TF 17) The effective interest rate is the stated or quoted interest rate by the financial institutions. Diff: 1 Type: TF 3

5 18) The nominal interest rate is the actual rate of interest you earn or pay. Diff: 1 Type: TF 19) The effective rate of interest and compounding frequency have an inverse relation. Diff: 3 Type: TF 20) Jill will have reached her goal of saving $ to buy a car if she puts away $420 a month in a 7% annual interest savings account for four years. Diff: 3 Type: TF 21) Your rental payment required at the beginning of each month is an annuity due. Diff: 3 Type: TF 22) Your monthly life insurance payments due at the beginning of each month are an annuity due. Diff: 2 Type: TF 23) To calculate the present value, all you need is the amount of money in the future, the interest rate, and the number of years the money will be compounded. Diff: 2 Type: TF 4

6 24) John wants to have a $ down payment for his car in three years. If he puts away $7,000 today and gets a 12.6% annual return, he will have the money he needs. Diff: 3 Type: TF 25) Future value interest factor (FVIF) uses $1.00 to calculate the $1.00 over time with a given interest rate and the number of periods the $1.00 is compounded. Diff: 2 Type: TF 26) Mary deposits $4000 at the beginning of each year and the money will grow to $ in 30 years with 12 percent compounded annually. Diff: 3 Type: TF 27) ABC Bank offers term deposits with 7.8 percent compounded quarterly, while XYZ Bank offers term deposits with 8 percent compounded annually. We know that ABC Bank offers a higher effective rate of return. Diff: 3 Type: TF Categories: Interest Rate Conversion 28) ABC Bank offers term deposits with 8 percent compounded annually, while XYZ Bank offers term deposits with 7.9 percent compounded monthly. ABC Bank offers a higher effective yield. Diff: 3 Type: TF Categories: Interest Rate Conversion 5

7 29) Discount refers to the process of earning interest on interest. Diff: 1 Type: TF 30) If you borrow money, you will receive interest. Diff: 2 Type: TF 31) Fred is 29 and just sold an antique for $ that he purchased at age nine for $ Fred's annual rate of return on this antique is 7.2 percent. Diff: 3 Type: TF 32) The higher the interest rate, the higher the present value, other things being equal. Diff: 2 Type: TF 2.2 Multiple Choice 1) Approximately how much would you need to invest today, to receive $200 in ten years, if you received an annual interest rate of ten percent? A) $65 B) $77 C) $87 D) $97 Answer: B 6

8 2) The present value interest factor is A) always less than 1.0. B) always more than 1.0. C) assumes simple interest. D) always between 1.0 to 2.0. Answer: A Diff: 1 Type: MC 3) Financial institutions quote rates with different compounding periods. What is the term for the actual interest rate paid or earned? A) Effective B) Nominal C) Real D) Absolute Answer: A Diff: 1 Type: MC Categories: Interest Rate Conversion 4) What is the term for the interest rate financial institutions quote? A) Nominal B) Effective C) Annual D) Real Answer: A Diff: 1 Type: MC Categories: Interest Rate Conversion 5) If you have an investment that will receive $100 at the end of year one, $200 at the end of year two, and $300 at the end of year three, what is the market value of this investment today if the discount rate is 13 percent annually? A) $553 B) $453 C) $423 D) $383 Answer: B 7

9 6) Mary wants to have $150 after four years by depositing $100 today and earning six percent interest compounded annually for the next six years. Can Mary attain her financial goal of having $150 lump sum six years later? A) Yes, future value is more than $150. B) Yes, present value is more than $150. C) No, present value is less than $150. D) No, future value is less than $150. Diff: 1 Type: MC 7) What is the future value of $200 deposited today at eight percent interest compounded annually for three years? A) $252 B) $250 C) $248 D) $249 Answer: A Diff: 1 Type: MC 8) What is the highest effective rate attainable with a 12 percent nominal rate? A) percent B) percent C) percent D) percent Answer: B Categories: Interest Rate Conversion 9) If John makes annual year-end payments of $ on a 20-year loan with an annual interest rate of 7.5 percent, what is the original principal amount for John's loan? A) $ B) $ C) $ D) $ Categories: Present Value of an Annuity 8

10 10) An antique was originally purchased 50 years ago for $2 and today is worth $600. What is the approximate annual rate of return realized on the sale of this antique? A) 18 percent B) 12 percent C) 9 percent D) 13 percent Answer: B 11) Nick invests $ today and the fund guarantees an annuity of $ for six years. What is the approximate rate of return? A) 11.6 percent B) 8.0 percent C) 12.5 percent D) Insufficient information to calculate Answer: C Categories: Present Value of an Annuity 12) Danny invests $ in a fund and expects to receive $ per year for the next 30 years. What is the approximate interest rate provided on the annuity? A) 8 percent B) 6 percent C) 9 percent D) 7 percent Categories: Present Value of an Annuity 13) What is the present value of an ordinary annuity paying $1550 each year for 15 years, with an interest rate of 6.6 percent per annum? A) $ B) $ C) $ D) $ Answer: C Categories: Present Value of an Annuity 9

11 14) The future value of $676 deposited at 5.85 percent compounded annually for five years is closest to A) $845. B) $962. C) $907. D) $ ) If the interest rate is zero, the future value interest factor equals A) 0.0. B) C) 1.0. D) Undefined Answer: C Diff: 1 Type: MC 16) How long will it take Ivy's money to triple in value at 12 percent compounded quarterly? A) 9.5 years B) 9.7 years C) 9.3 years D) Not enough information Answer: C 17) If you borrow $ as a five-year loan from the bank and the bank requires you to make end-of-year payments of $ , what is the annual interest rate on this loan? A) 8 percent B) 6 percent C) 7 percent D) 4 percent Answer: C Categories: Present Value of an Annuity 10

12 18) Betty wants to accumulate $1 million by the end of 20 years by making equal annual yearend deposits over the next 20 years. Assuming Betty can earn 10 percent over this period, how much must she deposit at the end of each year? A) $ B) $ C) $ D) $ ) In a recessionary economy, the interest rate on deposits can be 0 percent. However, Raymond has an investment of $ now, and in three years it will mature and pay Raymond $ What is the approximate annual interest rate he will receive? A) 9.3 percent B) 8.6 percent C) 8.9 percent D) Insufficient information to calculate this question Answer: B 20) Assuming an inflationary economy, the future value interest factor is A) always equal to 1.0. B) always less than 1.0. C) always greater than 1.0. D) always uncertain. Answer: C Diff: 1 Type: MC 11

13 21) The future value of $810 deposited today at 7.71 percent compounded annually for four years is closest to A) $1620. B) $1090. C) $1060. D) $1066. Answer: B 22) What is the present value of $1000 to be received ten years from today, assuming an interest rate of nine percent per annum? A) $402 B) $488 C) $470 D) $422 23) The amount to be invested today at a given interest rate over a specified period in order to equal a future amount is called A) present value interest factor. B) future value. C) present value. D) future value interest factor. Answer: C Diff: 1 Type: MC 24) The future value of today's $200 to be received 10 years later with an interest rate of 10 percent per annum is A) $424. B) $484. C) $542. D) $

14 25) If you want to have $ for a down payment on a new car in three years' time, assuming an interest rate of 4.5 percent compounded annually, how much money do you need to deposit as a lump sum today? A) $8650 B) $8712 C) $8112 D) $ ) Raymond wants to save the college tuition fees his child will need in ten years by starting with a deposit of $6500 today and depositing another $500 at the end of each year. How much will Raymond have in ten years if he gets a rate of return of four percent? A) $ B) $ C) $ D) $ Answer: A 27) If you want to save $ for a down payment on a home in five years, assuming an interest rate of 4.5 percent compounded annually, how much money do you need to save each month? A) $666 B) $609 C) $622 D) $597 13

15 28) Hazel needs to plan the mortgage amount she can afford. How much would she need to pay monthly on a mortgage of $ at six percent interest, calculated semi-annually and amortized over 30 years? A) $555 B) $1211 C) $1199 D) $1190 Categories: Present Value of an Annuity 29) How much interest would Aleem save if he paid off his mortgage over 15 years instead of 30 years? His mortgage is $ at six percent interest calculated semi-annually. A) $ B) $ C) $ D) $ ) Julian is a student relying on student loans. He feels he would like to borrow an extra $4000 each year for the next four years to take vacations to recover from studying. Assume that no interest accrues until he completes his education and begins paying off the loan. The interest rate for the loan amount will be seven percent per year compounded monthly and he will pay it off over five years. What would his monthly payment be on this loan? A) $374 B) $267 C) $271 D) $317 14

16 31) Rebecca is retiring next month when she turns 65. She can select a pension of $1745 monthly guaranteed for the rest of her life, but not indexed for inflation, or take a lump sum of $ Assume she can invest the lump sum at five percent annually and draw the same income as the pension. What age must she reach for the monthly pension to be the better choice? A) 89 B) 90 C) 92 D) 93 Answer: C 32) Jessie won a lottery and was given the following choice. He could either take $5000 at the end of each month for 25 years, or a lump sum of $ Assume annual compounding and determine what interest rate he would have to beat for the lump sum to be the better choice. A) 3.1 B) 12.3 C) 7.0 D) ) Ishan plans to retire at age 40 with a decent lifestyle. He assumes that he can safely earn a real return of 4% annually on his money and that he would need $4000 a month to last until he turned 90. How much money would he need to have accumulated at age 40 (to the nearest thousand) if he were going to retire and no longer earn any money? A) $ B) $ C) $ D) $ Answer: A Categories: Present Value of an Annuity 15

17 34) Mortgages are annuities in that a fixed monthly fixed amount to the lender (assume monthly payments and an interest rate that compounds semi-annually). Sara is planning to take on a mortgage of $ and believes she can afford monthly payments up to $700. How much interest would she save if she decided to pay off her mortgage over 20 years, rather than over 25 years? Her mortgage is at five percent interest calculated semi-annually. A) $ B) $ C) $ D) $ ) Alexis wants to have saved $ by the time she retires at age 60. She is turning 46 in the next week and has accumulated $ in her RRSP accounts. Assuming she can continue to get a 6% annual return on her RRSP investments, how much does she need to keep saving each month to reach her goal? A) $2262 B) $1467 C) $2102 D) $396 36) The most important thing to note about an annuity is A) that the payment must not change over time. B) that the payment increases according to the discount rate. C) it reflects the growth of a single lump sum. D) that it reflects the power of simple interest. Answer: A Diff: 1 Type: MC 16

18 37) Naldo is considering selling a painting he inherited from his grandparents and which cost $200 when purchased 72 years ago. He accepted an offer for $ for it recently. What is the annualized rate of return on this painting? A) 1.12% B) 2.75% C) 11.7% D) 6.75 % 38) Tracey is buying a condo and will have a mortgage of $ which she plans to pay off in 25 years. The interest rate is 5% compounded semi-annually. Her payments would be $1046 a month. She has heard she can reduce the time it would take to pay off her mortgage if she pays $523 every two weeks instead. How many years it would take her to pay off her mortgage if she chooses the second option. A) 10.2 years B) 21.7 years C) 25.0 years D) 21.5 years 39) If your credit card says 28% interest compounded daily, what is the effective interest rate? A) 32.3% B) 29.8% C) 31.9% D) 28.9% Answer: A Categories: Interest Rate Conversion 17

19 40) In which situation is simple interest the most appropriate interest calculation to use? A) When there is one compounding period B) Never C) Always D) When there are two or less compounding periods Answer: A 41) Joe and Bill are the same age and starting their careers. Each plans to retire at age 65 and each wants to have $ in his RRSP account by then. If they both get seven percent annual return on their RRSP savings, which one will be closer to reaching his goal? A) Bill if he starts saving $800 a month when he is 45 years old B) Joe if he starts saving $200 a month when he is 25 years old C) Bill if he starts saving $1000 a month when he is 45 years old D) Joe if he starts saving $150 a month when he is 20 years old 42) What is the effective interest rate for a car loan advertised at five percent compounded monthly? A) 5.1% B) 5.2% C) 5.3% D) 5.4% Answer: A Categories: Interest Rate Conversion 43) If Jenn could get a 10 percent annual return on her investment holdings, how long would it take for her to double her money? A) 7.3 years B) 6.9 years C) 10.0 years D) 83.5 years Answer: A 18

20 44) Selena wants to have enough funds to cover $ per year for four years of her daughter's university expenses and will need the money at the beginning of each year. If her funds get an annual return of 4.3 percent, how much would she need to have in the account when her daughter starts university? A) $ B) $ C) $ D) $ Categories: Present Value of an Annuity 45) Ruby is expecting her first child next month and would like to have $ saved for university education when the child turns 17. If Ruby can get a 6.6 percent annual return on the education savings for her child, how much does she need to start saving each month once the baby is born? A) $2688 B) $392 C) $224 D) $218 46) Ralph wants to know what he should be able to save in his child's RESP account if he contributes $2,500 per year and also gets the CES grant of $500 each year. He wants to assume a conservative investment return of four percent annual return and that he will only contribute until the child is 15 (assume 15 years of $3000 deposits). A) $ B) $ C) $ D) $

21 2.3 Essay 1) Assuming a discount rate of 14 percent per year, Peter wants to know the market value of his investment today based on the following cash flows. Explain your reasoning. Year Cash flows 1 to 5 $ per year 6 to 10 $ per year Answer: Present value of years 1-5 This first part a five year annuity P/Y is 1, C/Y is 1 FV = 0 I/Y = 14 N = 5 PMT = CPT PV = The second part is another five year annuity, the rest of which need to be discounted again to the present time to determine current market value. FV = 0 I/Y = 14 N = 5 PMT = PV yr 5 = $ Then to PV it to now, FV = I/Y = 14 N = 5 PMT = 0 PV yr 5 = $ So based on the discount factor of 14%, the market value today would be $ Diff: 3 Type: ES Categories: Present Value of an Annuity 20

22 2) Develop an example to illustrate the power of compound interest. Be sure to illustrate your points using numbers and calculations. Answer: There are many possibilities. Comparing a simple interest example versus compound interest over many years. Illustrating that saving $200 per month for 40 years at 7% return is more than saving $800 a month for 20 years with the same return. Example: Saving $200 per month from age 25 to 65 at 7% return would give a future value of $ I/Y 7, N 40 12, PMT -200, PV 0 and CPT FV And $ was actually saved - $ Compare with the future value of saving $800 per month for 20 years at 7% return. I/Y 7, N 20 12, PMT - 800, PV 0 and CPT FV $ And $ was actually saved - $ Diff: 3 Type: ES 21

23 3) Use an illustration to show the difference between annual, semi-annual, monthly and daily compounding. Give examples and illustrations using numbers from real life for each one. Answer: Annual interest: Means the interest is charged or paid once per year - for example, on some GICs, Canada Savings Bonds. Example: $1000 at 4% interest would give you $1040 at the end of the year. Semi-annual interest: This means the interest is calculated half at the middle of the year and then half at the end of the year. This applies to most bonds and mortgages. Example: A $ bond paying 6% interest pays $300 interest at the middle of the year and $300 at the end of the year. When you assume that you would have interest growing on the first $300, you realized that you would have more than $600 interest at the end of the year. Monthly interest: Example: A line of credit or car loan would normally have interest calculated monthly. Again this will end up being a higher actual or effective rate, than if it were compounded annually. Daily interest: Example: Most credit cards charge interest daily. For example, a credit card charging 21% but calculated daily would give an effective rate of 23.36%. Diff: 3 Type: ES Categories: Interest Rate Conversion 22

24 4) Review all the considerations in a decision to take either a lump sum payment of $ from a pension plan at retirement (age 65) versus a guaranteed monthly payment for life of $3000 (a life annuity). Assume the tax implications are neutral. Use calculations to illustrate your points and indicate what assumptions you use. Give your opinion on the best option. Answer: Pros of the annuity: Life expectancy - the risk of living past expectation, say 25, 30 or 35 years and being impoverished in extreme old age. Consider that a 3% return and life expectance of 20 years (to age 85) would produce $3300 per month, so it seems you are not getting a good deal with $3000 a month. But if you feel you may live to age 100, then it is a great deal. (I/Y 3, N 20 12, PV $ , FV 0) CPT PMT $3300 If you assume would get paid until age 85, you would be getting an effective interest rate of 1.9% which is not very high. (N 20 12, PV , PMT $3000, FV 0) CPT I/Y 1.9% However, with the annuity you get the security of a guaranteed income for life. This gives safety, security and peace of mind. Ability to plan your lifestyle and monthly cash flow expenditures. Pros of the lump sum: More flexibility with what you can do with your money. More control over your money. More control over what you pass on to your heirs. If you had taken the annuity and then died at age 75, the value to you would only have been $ (I/Y 1.97, N 10 12, PMT $3000, FV 0) which is much less than $ It would then be much better for your heirs if you happen to die early, to have the lump sum. Hopefully you can get better than a 3% return, so would be better off. But what if you live a long time? If you could get a 4% annual return and lived until age 95, $ would be sufficient to provide only $2630 a month, so you would have run out of money if you were spending $3000 a month. (I/Y 4, N 40 12, PV $ , FV 0) CPT PMT $2630 Your opinion... Diff: 3 Type: ES Categories: Present Value of an Annuity 23